An Update on the Securitization of Small Business Loans

There have been at least three developments in small business
securitization, in addition to the rise of credit scoring, since The Region last looked at the issue (see "Will
the Securitization Revolution Spread?" September 1995).

First, the amount of small business loans
that have been securitized has nearly doubled since fall 1995.
While no exact numbers were available, it appeared that less than
$900 million in small business loans had ever been securitized
at that time. An equally rough update suggests that about $2 billion
in small business loans have now been securitized. This figure
remains small when compared with the roughly $175 billion in commercial
and industrial loans under $1 million outstanding as of June 1996.
SierraWest Bancorp of Truckee, Calif., carried out a particularly
noteworthy transaction being the first bank to securitize the
unguaranteed portion of so-called 7(a) loans, which receive a
partial guarantee from the U.S. Small Business Administration
(SBA).

Second, Congress made the SierraWest transaction
possible by passing legislation in 1996 that forbid the securitization
of the unguaranteed parts of SBA loans after March 31, 1997, unless
the SBA issued rules that treated all lenders equally. Previously,
the SBA did not allow banks and other depositories to engage in
such securitizations, while it did allow securitization by nondepository
lenders, such as a subsidiary of the Money Store. The SBA issued
a proposed rule in February 1997 that allowed securitization for
all, while requiring securitizers to effectively own a 5 percent
interest in each securitized loan. The SBA also specified three
methods to structure lenders' interest in the loans.

The SBA provides an average guarantee of repayment
on 75 percent of the 7(a) loan (down from 90 percent several years
ago). The SBA does not want lenders making loans on which only
the SBA and investors could lose funds when defaults occur. Therefore,
the SBA wants lenders to retain an ownership stake so that they
will lose some money upon defaults even if they sell the loan.

Nondepositories that would become subject
to these loan ownership restrictions for the first time have lodged
numerous complaints. They argue that the 5 percent rule is arbitrary
and inefficiently requires the same credit protection and structure
for all lenders. Moreover, they believe that investors already
act to ensure that lenders bear risk in securitization. Securitizers,
for example, already bear the risk of loss from certain delinquent
loans. Current structures also ensure that originators earn higher
returns when losses are low. In response to the controversy, the
SBA issued an interim rule in April 1997 allowing depository and
nondepository institutions to securitize unguaranteed 7(a) loans
subject to a case-by-case review. Finally, several firms have proposed ventures
that should make the securitization of small business loans originated
by small lenders more likely. A small lender may not make enough
small business loans to justify the expense of securitization.
A larger firm that buys loans from smaller lenders and securitizes
a large volume on a regular basis could better take advantage
of cost efficiencies.

However, the heterogeneity of small business
loans has made it difficult for a firm to act as a conduit to
the securitization market for small business lenders. In one of
the new ventures, a firm that sells software to banks has teamed
with a securitization specialist to create the "Loan Origination
Management and Exchange" (Lori Mae for short). Lori Mae hopes
to facilitate homogenous loan pools by securitizing only loans
originated with the co-owner's software. A second venture called
the Small Business Funding Corp. plans on purchasing the unguaranteed
portion of SBA 7(a) loans from smaller lenders. This firm counts
on the rise of credit scoring to help standardize small business
loans and make estimates of expected cash flows reliable. Finally,
California Imperial Bancorp announced that it would start purchasing
and securitizing small business loans in 1998.